KEY POINTS:
When California homeowner Christopher Aultman stopped writing mortgage cheques, Charles Prince of Citigroup paid.
Some of the US$16.6 billion ($21.5 billion) that Prince's New York-based bank estimates it lost on wrong-way sub-prime bets flowed to investors who for the first time were able to wager that US mortgages would collapse. The sub-prime derivatives market created in 2005 by a group of Wall Street bankers made that payday possible.
The derivatives were based on sub-prime mortgages, given to borrowers with bad or incomplete credit. Securities firms packaged and sold that debt in structured financial products where the risk was hidden by investment-grade ratings and the values proved impossible to calculate.
"These structured products were crazy profitable for Wall Street until they blew up," says Randall Dodd, senior financial sector expert for the International Monetary Fund in Washington.
"Ultimately it's about excessive risk-taking and greed."
The risks were amplified by the derivatives, contracts whose values are derived from packages of home loans and are used to hedge risk or for speculation. The vehicles allowed investors to bet against particular pools of mortgages.
The magnified losses caused by derivatives made it possible for a small number of defaulting sub-prime borrowers to freeze world credit markets.
That's what happened in July after payments in the first quarter stopped on 13.8 per cent of sub-prime mortgages representing 4.8 per cent of total US borrowers. The defaults caused demand for sub-prime securities to dry up. Uncertainty over the value of the financial products spread to investment funds globally.
Corporate lending stopped because no one knew what collateral was worth. By August 10, the Federal Reserve and the European Central Bank were forced to inject a combined US$275 billion into the banking system to keep money flowing.
The hedging offered by derivatives made investors feel invulnerable, says Paul Kasriel, chief economist at Northern Trust in Chicago.
"Derivatives don't reduce risk, they shift risk," Kasriel says. "The development of the derivatives market enabled investors to shift risk at a lower cost, and that encouraged them to take on more risk."
From 2001 to 2006, as US home prices rose 50 per cent nationally, owning the debt and guessing that borrowers would keep current paid off. Since July 2006, however, when housing supply began to outstrip demand and the number of late payments started to rise, the short position, or wagering against the performance of mortgages, has prevailed.
Many of those responsible for the economic upheaval caused by sub-prime derivatives have also been its victims.
Mortgage salesmen peddled loans "based on the borrowers' ability to refinance rather than the borrowers' ability to repay", said David Einhorn, co-founder of Greenlight Capital LLC in New York and a former director of New Century Financial, the second-biggest sub-prime lender in 2006, at an investors conference in October.
If the borrowers defaulted, the mortgage salesmen still got their commissions.
Now many of them are jobless and broke.
Daniel Sadek, who says his Costa Mesa, California, sub-prime lender Quick Loan Funding catered to borrowers with credit scores as low as 420 out of 850, had to close shop in August when Citigroup cut the company's US$400 million credit line.
"I'm surprised they went under," says borrower Kathy Cleeves of Tenino, Washington. "They made a fortune off us."
Borrowers bought houses and took out equity loans they couldn't afford. That didn't matter. As home prices kept rising they could always refinance. Now many of them face foreclosure.
Aultman, a Union Pacific Railroad mechanic with an average credit score of 465, took US$21,000 in cash out of a 2005 refinance with Quick Loan Funding. The payments on his house in Victorville, California, adjusted to $2650 last month, almost double what he was paying for the fixed-rate mortgage he had before the refinance. He was planning to refinance again before he discovered that he couldn't qualify.
Bankers bought loans to turn into securities that gave them the highest yield. If the borrowers defaulted, the bankers still got their fees. Now the losses are piling up.
The biggest securities firms worldwide are collectively expected to write down about US$89 billion in sub-prime-related losses in the second half of 2007.
Citigroup, the biggest US bank, said it would write down as much as US$11 billion in assets on top of US$5.6 billion already announced. Citigroup was one of a "group of five" Wall Street firms that created the sub-prime derivatives market.
Morgan Stanley, the second-biggest US securities firm, recently wrote down US$9.4 billion in mortgage-related investments.
"Our assumptions included what at the time was deemed to be a worst-case scenario," said chief financial officer Colm Kelleher on December 19. "History has proven that that worst-case scenario was not the worst case."
Bear Stearns announced a US$1.9 billion writedown on mortgage losses in November, sending the New York-based firm to its first quarterly loss since it went public in 1985.
Merrill Lynch, the world's largest brokerage, and UBS, Europe's biggest bank by assets, dismissed their chief executives after they reported a combined US$11.4 billion in sub-prime-related losses in the third quarter.
Investors didn't know what they were buying, says Sylvain Raynes, a principal in New York-based R&R Consulting and co-author of the book The Analysis of Structured Securities. It didn't matter if a certain number of borrowers defaulted because the returns on some parts of the financial instruments were as much as 3 percentage points higher than 10-year Treasury yields.
Now the losses are spreading. Florida schools and cities pulled almost half their deposits from a US$27 billion state investment pool linked to sub-prime mortgages.
A hospital management company in suburban Melbourne, Australia, lost a quarter of its portfolio in July on sub-prime-linked investments.
Japan's 36 banks booked combined losses of 244 billion ($2.8 billion) in the fiscal first half on sub-prime-related assets, according to the Financial Services Agency.
Eight towns in northern Norway, including Hattfjelldal, a village where reindeer outnumber the 1500 residents, lost a combined 350 million kroner ($83 million) on securities containing sub-prime mortgages.
"We are a stoic people, used to fighting against the forces of nature, so we'll manage," says Hattfjelldal mayor Asgeir Almaas. "We won't let this break us." Nobody paid more dearly than Savannah Nesbit. The 6-year-old and her family lost their house in Boston's Dorchester neighbourhood after failing to pay a sub-prime mortgage that adjusts higher every six months.
Savannah got her first bicycle for her birthday in August, pink with streamers dangling from the handlebars. She decorated the present from her grandmother with stickers of Dora the Explorer, her favourite animated character.
When sheriffs deputies emptied the house and changed the locks, they left Savannah's bike behind.
"She cries about that bike every night, and she wants me to buy her another one, but I can't afford it right now because I have my own financial problems," says Savannah's grandmother, Anne Marie Wynter, whose home is also in foreclosure.
Sadek's Quick Loan Funding had 700 employees at its 2005 peak. Now Sadek is making payments on three residential properties he mortgaged in a failed attempt to keep his firm afloat. He also owns a restaurant in Newport Beach, California.
"I'm under water," he says, puffing on a Marlboro Light.
"I'm trying to sell everything, and nothing is being sold."
His attempts to bankroll a film career for his former fiancee, soap opera actress Nadia Bjorlin, came to naught. In November, Bjorlin returned to her role as Chloe Lane on Days of Our Lives.
Aultman, the railroad mechanic, teeters on the brink of foreclosure. He has been trying to modify his loan terms with Countrywide Financial, which now owns his mortgage.
"It's scary, very scary," Aultman says. "Sometimes I'll walk through the house and touch the walls and say to myself, 'This is mine'."
Moody's, S&P and Fitch continue to be arbiters of the quality of securities, though their reputations have suffered.
The Connecticut Attorney-General is investigating the three companies, including whether they rank debt against issuers' wishes and then demand payment. Two other states, New York and Ohio, have launched separate investigations of the ratings companies.
- Bloomberg
